Annuities … Promises of guarantees and no loss?

What tends to be forgotten, or at least not mentioned or emphasized, is that in order to purchase an annuity for the income desired, a sum of money has to be removed from the portfolio to do that. What is the income cash flow from that sum of money in the first place before such an annuity purchase? How do the two income streams compare, keeping the sum in portfolio versus buying the annuity?

I’ll also point out, that any money you use to buy an annuity for income, is money not in your portfolio providing income through those holdings.

There are two different issues when it comes to comparison. If an immediate annuity is purchased (income from the annuity purchase begins within a year), those payments tend to be fixed income without cost of living adjustments (COLA) for inflation. Thus, the purchasing power of the annuity declines with age going forward because of the effect of inflation. How does that income compare with the income cash flow if the funds had remained in a portfolio going forward? A well structure portfolio will tend to keep up, or stay ahead, of inflation’s effects on purchasing power.

These types of evaluations and comparisons are rarely, if ever, done today. Software should make an apples-to-apples comparison between the choices where the sum of the incomes between the two choices are properly adjusted in real dollar terms.

Yes, COLA adjustments could be bought with the immediate annuity purchase, but those initial payments are reduced relative to a non-COLA. What if inflation exceeds those fixed COLA amounts? You’d still suffer a loss of purchasing power over time, where a portfolio approach may keep up with inflation since a positive real return is one of the objectives of investing in the first place. And with those COLA adjustment payments, the amount required to purchase the annuity income stream goes up as well. What is the portfolio income cash flow stream lost from that extra annuity purchase requirement?

There is an illusion some have about steady income while working and that carries over into the desire for steady income once retired. There is also the fear of losing all their money in a portfolio. Is all your portfolio at risk of loss? It shouldn’t be at risk if a global approach to indexing matched with proper portfolio construction are used.

What kinds of annuities are there?

Note that the discussions here talk about annuities, but rarely compare and contrast those to simply keeping money invested through a total return portfolio approach. Sometimes it may be prudent to have both kinds of income streams – Social Security a form of non-portfolio based income streams.

I’ve been describing income annuities above.

Of income annuities, there are single premium immediate annuities (SPIAs) or Deferred Income Annuities (DIAs) bought with lump sums. There are pros and cons to immediate annuities.

There are also deferred annuities where you buy the annuity, but delay indefinitely when you wish income to begin. In other words, you defer the income decision.

There are consequences to heirs as to whether those beneficiaries receive any benefits or not. It depends on the type of annuity you buy and what the annuity contract stipulates.

Taxation of annuities is also NOT as straight forward as many think.

Here’s a prior article I wrote on variable annuities “Can Variable Annuities Really Offer Insurance Guarantees Against A Market Catastrophe?”

Indexed annuities are all the rage. Insurance sales people tout the pros and rarely if ever discuss in depth the cons of these insurance contracts. This is a great short article on both the pros and cons of indexed annuities: “Indexed Annuities: Have You Been Framed?”… where “the framing effect” is used against you.

Additionally, annuities are NOT investments – they are contracts with an insurance company where the insurance company deploys the money in different ways depending on what kind of annuity you bought. There are reasons not to buy annuities, complexity, fees, the fact that they are contractual, etc. Even though the insurance company invests in different markets, you are still dependent on strength of that one insurance company where you may lose some or all value (and guarantees) based on what happens to the insurance company (concentration risk – see PS below), and not what happens in the different investment markets that can be mixed for diversification.

Jane Bryant Quinn says this  about annuities in this interview

Quote “Why do you dislike fixed indexed annuities?

People don’t realize that they’re priced to compete with bonds. But they have this apparent link to stocks — that you have an equity investment of some sort. So with a fixed indexed annuity, you’re basically buying a bond and paying a high annual price for it.

Anything else that you think is a big negative?

They’re supposed to be annuitized. People are told: You’ll be paid 5% for the rest of your life. But of course you aren’t earning 5% on your money. They’re parceling out 5% of your own money to you.” Unquote.

You may guess that I’m not fond of most annuities for the reasons best expressed here by Edelman better than I can: “7 Reasons I’m not Fond of Annuities.”

Insurance companies have to participate in markets too. So when you buy an annuity you’re simply transferring risk to the insurance company. They can’t invest your money risk free and promise greater returns or guarantees without charging fees to make up the difference between the guarantees they promise and the market returns they receive, otherwise they would go out of business, and then what good is that guarantee in the first place (more on this in PS. below).

As you may gather, annuities are not straight forward insurance company contracts,  full of complexity and not-so-transparent fees. Simply taking a prudent and diversified portfolio approach for total return (as opposed to interest or dividends only which tilt portfolios away from broader diversification) simplifies retirement income planning, beneficiary planning, and with prudent use of longevity tables can utilize “personal mortality credits” and thus estate planning for portfolio funds that remain.

I do suggest immediate annuities in certain situations that need a pension type income for those who are unsure of their ability to manage catastrophic spending (e.g., medical), or over spending (spendthrift) relative to their daily and monthly needs.

PS. Who guarantees the guaranteer (insurers)? Answer: State Guaranty Associations, who themselves may have problems [“New York is the only state that has a pre-assessed guaranty fund, meaning that insurance companies domiciled in New York have already been assessed for their share of the guaranty fund money, based on the company’s premium income in New York, and the money is already there in the event of an insolvency. All other states that have guaranty fund laws have post-assessment vehicles. That is to say that if a company in a state other than New York goes insolvent, insurance companies domiciled in those states would then be assessed after the insolvency is declared.” Moral hazard structure? [“State guaranty funds also differ in some of the coverages that come under their protection. While all state guaranty funds cover auto and homeowners insurance claims, some other types of insurance may not be covered. In some states, annuities, life, disability, accident and health, surety, ocean marine, mortgage guaranty and title insurance may not be covered.” So, check your State’s coverage to be sure.]

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